CEO SUMMARY: Back in April 2004, when American Esoteric Laboratories, Inc.(AEL)launched operations, its declared ambition was to become a national esoteric testing firm. However, given the positive experiences from its acquisition of Memphis Pathology Laboratories in September 2004, AEL has evolved its core business strategy to include routine testing and to focus on regional hospital and physician office opportunities.

WHAT’S IN A NAME? At its birth, American Esoteric Laboratories, Inc. (AEL) stated that it wanted to be a “full-service provider of esoteric clinical laboratory services to hospitals and specialist physicians.” (See TDR, April 26, 2004.)

For that strategic vision, its name was certainly descriptive. Yet, in the 30 months since its formation, American Esoteric Laboratories has found itself acquiring three laboratories which primarily provide routine testing services to office-based physicians. The most recent example was just 27 days ago, when it announced the acquisition of DRL Labs, Ltd. (DRL), based in Tyler, Texas.

To learn about AEL’s current business strategy, THE DARK REPORT recently caught up with the executive team of American Esoteric Laboratories, including Brian Carr, Chairman & Chief Executive Officer; Jim Billing- ton, President & Chief Operating Officer; and Robert Walker, Vice President of Sales and Marketing.

“We’ve learned much about the competitive marketplace during the past several years,” observed Carr. “AEL entered the market with a clear strategy and no legacy assets. We wanted to be close to our customers and learn how to differentiate ourselves from existing lab competitors.

“That’s allowed us to spot opportunities for growth that were unanticipated at start-up,” he continued. “Probably the first insight was that the best way for AEL to access a sufficient volume of esoteric specimens was to serve the physicians’ office segment, along with the hospital market.”

Building Relationships

“There are two reasons why this is true,” noted Billington. “First, by providing specialist physicians with testing in their group practice, AEL is building a business relationship with these doctors that carries over into the hospitals where they admit patients. If they use us in their office-based practice, they will be comfortable having AEL as an esoteric test provider in their hospital.

“Second, it is widely-known that outpatient services are growing faster than inpatient services,” explained Billington. “In fact, this growth in outpatient procedures means that the volume of esoteric testing done in doctors’ offices is, by our estimates, growing twice as fast as esoteric testing volumes done in hospitals.”

“These two insights pointed us to a slightly different business opportunity,” interjected Carr. “By offering both esoteric and routine testing directly to physicians, we would build a client base that provided strong rates of organic growth. At the same time, even as we cultivated client relationships with specialists, it would be easier for AEL to develop client relationships with hospitals in these same communities.”

Reinforcing this business perspective was the experience of another national reference lab company. “We studied the success Esoterix has had developing business relationships with cancer centers and infectious disease specialists,” observed Walker. “In today’s health system, until the patient reaches the end stage of many diseases, care is provided by office-based physicians.

“These insights caused us to rethink several key aspects of our original business strategy,” Carr stated. “If we wanted to emphasize esoteric testing services to office-based physician specialists, then routine testing now becomes part of the necessary service menu. To properly service office-based specialists, we need to provide the full spectrum of testing services, ranging from routine to esoteric. In turn, this quickly led us to realize that we could effectively provide superior service to primary care physicians in a profitable manner.”

Are Esoteric Testing Margins Under Pressure?

COMPETITION AND PRESSURE on reimbursement for esoteric testing has eroded the profit margins on such tests in recent years. That’s the belief of American Esoteric Laboratories.

“We think there is margin pressure on high-end esoteric testing work that originates from hospitals,” stated Brian Carr, Chairman and CEO of American Esoteric Laboratories (AEL), with headquarters in Nashville, Tennessee. “That’s a well-kept secret in the lab industry.

“Several facts support this conclusion,” he continued. “For example, it is widely-recognized that, even at annual revenues of $150 million, Specialty Laboratories was struggling to make money. Further, both Quest Diagnostics and Laboratory Corporation of America tell the investment community that the volume of esoteric testing is growing steadily and this business line enjoys good margins. But confirmation of those facts cannot be easily teased out of either company’s financial reports.

“Our belief is that, in today’s competitive marketplace, the margins on hospital- sourced esoteric testing are under sustained pressure,” explained Carr. “That is another reason why AEL’s business strategy has evolved to support acquiring regional laboratories. The additional volume of testing helps us reduce our overall cost per test.”

MPL Provided Insights

When AEL acquired Memphis Pathology Laboratories (MPL) in September 2004, it viewed the acquisition as one which opened a major channel for esoteric testing from both the hospital systems connected with MPL, as well as office-based physicians. “That acquisition helped us appreciate that several other resources were necessary to support both the routine and esoteric business,” said Carr. “These include a well-developed courier and logistics network, electronic test ordering and results reporting, as well as access to managed care contracts, to name a few.”

“Memphis Pathology Laboratories had these strengths,” commented Billington. “It was also a dominant provider in its service market. That acquisition is a great success story for us. In each of the past two years, MPL has posted growth rates of 13% or more. During this same time, MPL’s sales force has increased from eight to 13 people.”

“Based on this experience and these insights about the esoteric testing marketplace, we’ve refocused our business strategy,” said Carr. “We still intend to offer esoteric testing to our clients. What is different is that we want to develop a robust regional laboratory network that can service the needs of hospitals and physicians in their respective communities. We want our regional labs to have six characteristics.

“One, the regional lab has a dominant market share in the community it serves,” he explained. “That is true of MPL, Physicians Medical Lab, and DRL Labs.

“Two, the regional lab must have close operational and professional connections with local hospitals,” continued Carr. “Three, because of these hospital relationships, the regional laboratory offers an extensive menu of services. This includes a broad offering of routine, reference, and esoteric testing, along with enhanced informatics, and an efficient logistics network.

“Four, the regional laboratory must have access to important managed care contracts for that area. Five, if we are considering an acquisition, we like the candidate lab company to have a long history of serving the local community,” noted Carr. “Six, in cases where we acquire a laboratory, we would like it to have a relationship with an anchor hospital in the local community.”

Carr is quick to point out the AEL’s three most recent lab acquisitions meet all six characteristics. “We like these types of laboratories because they provide a solid base upon which we can grow the business locally,” he explained. “AEL is in active acquisition discussions with other labs which fit this profile.”

Although in business less than three years, the experience of American Esoteric Laboratories already provides insights into the competitive marketplace for lab testing services. Clearly, AEL finds the sales cost—and the time to convert—a new hospital reference client to be expensive, particularly if the margins on esoteric testing are being squeezed.

Routine Testing Opportunity

On the other hand, AEL is finding good opportunities in providing routine testing services to office-based physicians, then growing the revenues of the acquired lab- oratories. With a strong core of three primary laboratories and already at $100 million in revenue, AEL has clearly established itself as a credible competitor in the lab industry. The unanswered question is whether the esoteric test referrals from office-based specialists in these same communities will continue to be a significant source of operating profits.